Why today’s monetary reformists ask for too little

Proponents of narrow banking such as the Positive Money movement are pushing financial reform. Our financial system is indeed in desperate need of change. The debate in the UK, however, exposes the shortcomings in the logic of narrow banking in the digital age.

Monetary reformists have been excitedly looking forward to the first debate about money creation and society in 170 years, which took place in the UK parliament last Thursday. Judging by the news traffic that followed, this excitement was not widely shared. The Telegraph was the only major UK newspaper that announced this debate – as a spin for believers in monetary voodoo. Also telling is the fact that the chief whip of the Tories, Michael Grove, told his MPs they should go home on Wednesday afternoon. He did not consider this debate, initiated by the backbench business committee, as something worthy enough to delay the weekend of his MPs.

Addressing the wrong issues

How society should regulate the financial system is a tremendously important question for economic policy. Evidently, money and money creation are critical parts of our financial system. So being ignored by the broader public must be a severe disappointment for people who take interest in these questions.

This sting is especially painful since the financial crisis of 2007-08 revealed the desolate state of our financial system and the need for fundamental reform. Not even the MPs who enjoyed a long weekend instead of attending this debate would deny this need. Something in the most recent debate about monetary reform was missing, but what was it?

The remarks that hint at what might be missing to raise more attention did not come from the two MPs who sketched their ideas how to fundamentally reform the monetary system. No, it came from the defenders of the status quo. They still argue that they can and will “fix” banking.

Most monetary reformists do not spend sufficient energy to counter this claim. They observe that banking got out of control, and are right in their intuition that private money creation has something to do with it. But they fail to establish a convincing link between money creation and the financial crisis of 2007-08.

Indeed, the link is not direct. As a matter of fact, banking used to work. From the end of World War II to the 1970s the West did not experience any significant financial crisis. Bankers already had the privilege of money creation back then, but were not able to earn more than other private sector employees.

If the main line of argument is that money creation by banks is per se a problem, one will encounter arguments like this:

Catherine McKinnell:

“… our focus is that the banks need to be tightly and correctly regulated to ensure that they work for the whole economy, …”

Guy Oppermann:

“I missed the opening of the debate, so I have not heard everything that has been said, but I do not accept that it is all doom and gloom in banking.”

Andrea Leadsom:

“If the tap in my bathroom breaks, rather than wrenching the sink off the wall, I would prefer to fix the tap.”

All the arguments brought forth against monetary reform in this debate rested on two pillars: the observation that banking used to work in the past, without the problems we see today, and the hope that we can set it right again.

The digital revolution as a game changer

The problems originate from the government guarantees that banking – that is, money-creating – institutions enjoy. Deposit insurance and lender of last resort facilities are the privileges the government grants to banks. Governments guarantee banks’ liabilities because they fear the consequences of banking panics. Such panics have frequently occurred as a result of private money creation in the absence of a lender of last resort and deposit insurance.

The governments always knew about the dangers that come with guarantees. This is why they implemented a comprehensive regulatory framework such as capital requirements to prevent banks from abusing the guarantees.

For a while, the combination of government guarantees and a tight regulatory framework worked well.

But things started to fall apart in the 1970. With the digital revolution bankers got many tools at hand to circumvent banking regulations; shadow banking emerged. The problem that banking – that is, the creation of money – is not bound to institutions regulated as banks is called the boundary problem of financial regulation.

The history of the capital requirements by the Basel committee of banking supervision exemplifies the boundary problem of financial regulation. Basel I was implemented in the late 1980s, but even the very designers of Basel I acknowledged its failure ten years later. The revised Basel II quickly shared the fate of its predecessor, and Basel III has already been circumvented before its full implementation.

Banking can no longer be fixed

The “culprit” for the mess we are in today is the digital revolution. Information technologies undermined the functionality of banking regulation. Unconstrained banks and banking institutions massively increased the amount of private money. This fuelled the asset bubble that eventually burst and marked the beginning of the financial crisis of 2007-08.

While banking got out of control in the digital age, the statement of narrow banking proponents that private money creation always has been bad is inaccurate. This is why the defenders of the current monetary regime found it easy to discard the demands of Steve Baker and Michael Meacher for monetary reform.

We have to make a more convincing case if we want to reform the financial system. We have to think broader and stop trying to fix banking. And not only politicians want to fix banking, but also narrow banking sells itself as an approach to set banking right. This approach is a dead end.

Banking can no longer be fixed. In the digital age, banks will always find ways to circumvent banking regulation. In the book The End of Banking: Money, Credit, and the Digital Revolution, we further elaborate this claim. Once one considers the development of shadow banking, it becomes hard to deny that banking got out of control with the rise of information technology. If monetary reformists endorse this argument, Catherine McKinnell, Guy Oppermann, and Andrea Leadsom will struggle to discard demands for monetary reform next time.